A Manatt for Entrepreneurs Resource
Founders must contend with many important decisions early in the life of a startup, including selecting the appropriate corporate structure. Their choice of structure can have far-reaching and long-term consequences, and can shape the manner in which a company can grow. It may determine the type of investors a founder is able to solicit, whether venture capital will be willing (or even able) to invest, and how taxes will be assessed and distributed among stakeholders. Selecting an appropriate entity structure early on can help startups maintain much-needed flexibility for future growth opportunities. For emerging companies, the decision is often to adopt a C corporation structure; however, there are a few options available to founders. S corporations, limited liability companies (LLCs) and C corporations each have unique features and distinct drawbacks that a founder should consider before moving forward.
S Corporations
An S corporation is similar to the well-known C corporation, with some notable differences. Most significant for a rising startup, an S corporation is limited to having only 100 shareholders, each of who, with limited exceptions, must be a U.S. citizen or permanent resident and not a corporation or other entity. An S corporation can issue only one class of stock, which is permitted to have differences in voting rights but little else. This imposes limitations on both the investor type and the potential investor pool available to a startup, thereby inherently limiting the startup’s ability to effectively raise capital in order to scale. Founders are prevented from issuing preferred stock—often an essential tool for attracting large investors such as venture capitalists and angel investors. These types of investors typically seek preferred stock as a means of protecting their investment (because preferred stock generally has rights, preferences and privileges that are superior to those of common stock). The inability to issue preferred stock may serve as a hindrance to a startup’s ability to continue raising the capital it needs to grow. One of the advantages of S corporation status is that an S corporation does not pay income tax directly, but rather allocates any profit or loss it may have to its stockholders pro rata their ownership. This creates a single level of income tax, an advantage over the double level of taxation inherent in a C corporation (discussed below). Founders must ensure that an S corporation’s stockholders do not jeopardize such tax benefits by, for example, transferring shares to a nonresident alien (an individual who is neither a U.S. citizen nor a permanent resident). As a result, an S corporation will often impose transfer restrictions on its stockholders to help ensure the S corporation maintains its status. This requires additional planning, agreements and greater costs at the incorporation stage, when resources are typically tightly controlled. S corporations must also pay careful attention to filing deadlines to ensure they do not lose their S corporation status while contending with certain state requirements, as not every state taxing authority recognizes the “S” election. While it is possible for an S corporation to elect to become a C corporation, the tax treatment can impose significant tax burdens on the stakeholders, so careful planning and advice are often needed to avoid unforeseen negative tax consequences. While it is certainly possible to grow a business of significant size using the S corporation structure, founders must carefully consider the strict requirements of an S corporation—particularly the number and type of stockholders who may own interests in an S corporation—if they intend to eventually attract large institutional investments or seek an initial public offering.
Limited Liability Companies
An LLC is a popular legal structure. It is a business entity organized under state law that combines the liability protections of a corporation with the pass-through federal tax treatment of a sole proprietorship (in the case of an LLC with one owner) or a partnership (in the case of an LLC with more than one owner). LLCs have been readily adopted in real estate ventures and have increased in popularity in other industries. LLCs can have multiple classes of members, allowing founders to provide favorable terms to potential investors. While LLCs have somewhat less burdensome obligations than C or S corporations, they have significant drawbacks similar to the concerns with S corporations that may give founders pause before electing this entity form. Many angel, venture capital and pension plan investors are deterred or restricted from investing in LLCs, namely due to the tax treatment of investing in a partnership, as these investors do not benefit from, and may be adversely affected by, pass-through tax treatment. Additionally, if a startup desires to go public, it could face intense pressure to first convert to a C corporation, which can place a significant tax burden on an LLC’s members. Structuring a startup as an LLC may severely limit the number and type of investors that may be able to invest in the company.
C Corporations
The C corporation is arguably the most favored corporate structure for startups and large corporations alike and is the typical vehicle used to take companies public. It provides founders with long-term flexibility and a legal form familiar to all venture capital and major investors. Founders have significant discretion in creating a capital structure that allows a C corporation to issue several classes of shares with different rights and preferences, including the issuance of stock options to service providers (not an easy task under the LLC structure). While the tax treatment of a C corporation is not as favorable as an S corporation’s single level of taxation or an LLC’s pass-through tax treatment, many investors appreciate that the losses of a C corporation stay with the corporation as net operating losses and can often be used to offset corporate gains in later years. As opposed to an S corporation or an LLC, a C corporation does not allocate profit and loss to its stockholders, but rather pays taxes itself. C corporations also eliminate the pass-through of unrelated business tax income, which can present an issue for tax-exempt investors in venture capital funds.
Why it matters
While most corporate forms are effective in limiting liability and providing a means to raise capital, founders of a startup expecting to seek funding should look toward the tried-and-true C corporation. Venture capital firms and angel investors are both familiar and comfortable with this corporate form and, unlike with S corporations and LLCs, investors are rarely precluded from investing in a C corporation. A startup will face many challenges as it scales, and selecting the C corporation as its structure will help during every phase of its growth.